Set-Off of Losses from an Exempt Source Of Income

Issue for consideration

It is usual to come across cases of losses
on transfer of shares of listed companies held as long term capital assets.
These losses arise for several reasons including on account of erosion in
value, borrowing cost and indexation. Such losses, where on capital account,
are computed under the head ‘capital gains’. Any long-term capital gains on
transfer of listed shares, on which STT is paid, is exempt from liability to
taxation u/s. 10(38) provided the conditions prescribed therein are satisfied.

Sections 70 and 71 permit the set-off of the
losses under the head ‘capital gains’ against any other income within the same
head of income and also against the income under any other sources subject to
certain specified conditions.

An issue often discussed is about the
eligibility of the losses, of the nature discussed above, for set-off in
accordance with the provisions of section 70 and 71 of the Act. In the recent
past, the Mumbai bench of the Tribunal held that such losses are eligible for
set-off against income from other sources, while the Kolkata bench held that it
is not permissible to do so.

LGW Ltd.’s case

The issue arose in the case of LGW Ltd.
vs. ITO, 174 TTJ 553 (Kol.). In that case, the assessee incurred a loss of
Rs.5,00,160 on sale of listed shares for assessment year 2009-10. The loss was
claimed as a deduction in the computation of the total income by setting off
against the other income. The AO disallowed the set-off of loss in view of the
fact that section 10(38) exempted any income arising from the long-term capital
asset being equity share and as such the loss if any should be kept outside the
computation of the total income; thus, loss in view of section10(38), would not
enter the computation of total income of an assessee. The appeal of the
assessee against the said order was dismissed by the CIT(A). The assessee not
being satisfied raised the following ground before the Tribunal; “That the
learned Commissioner of Income Tax (Appeals) erred in confirming the
disallowance of loss of Rs.5,00,160 incurred by the assessee company on sale of
Long Term investment in shares.”

On behalf of the assessee, it was submitted
that section 10(38) of the Act used the expression “any income” and
therefore loss on sale of long term capital asset being equity shares should be
allowed as deduction. In reply, the Revenue relied on the order of CIT (A).

The Tribunal observed that the stand taken
by the assessee was not acceptable in view of the decision in the case of CIT
vs. Harprasad & Co. (P.) Ltd. 99 ITR 118 (SC)., and cited with approval
the following part of the decision : ‘From the charging provisions of the
Act, it is discernible that the words ” income ” or ” profits
and gains ” should be understood as including losses also, so that, in one
sense ” profits and gains ” represent ” plus income ”
whereas losses represent ” minus income ” (1). In other words, loss
is negative profit. Both positive and negative profits are of a revenue
character. Both must enter into computation, wherever it becomes material, in
the same mode of the taxable income of the assessee. Although section 6
classifies income under six heads, the main charging provision is section 3
which levies income-tax, as only one tax, on the ” total income ” of
the assessee as defined in section 2(15). An income in order to come within the
purview of that definition must satisfy two conditions. Firstly, it must
comprise the ” total amount of income, profits and gains referred to in
section 4(1) “. Secondly, it must be ” computed in the manner laid
down in the Act “. If either of these conditions fails, the income will
not be a part of the total income that can be brought to charge.’

The Tribunal noted that Supreme Court in
that case, took note of the fact that any capital gains  arising between April 1, 1948, and April 1,
1957 was not chargeable to tax and therefore had held that the condition, namely,
“the manner of computation laid down in the Act” which “forms
an integral part of the definition of ‘ total income’ ” was not
satisfied and in the assessment year, 
capital gains or capital losses did not form part of the “total
income” of the assessee which could be brought to charge, and therefore,
were not required to be computed under the Act.

The Tribunal held that the law laid down by
the Supreme Court clearly supported the stand taken by the Revenue and as a
consequence, the claim for deduction by way of set-off of loss was without any
merit and the same was dismissed.

Raptakos Brett & Co. Ltd.’s case

The issue arose in the case of Raptakos
Brett & Co. Ltd. vs. DCIT, 58 taxmann.com 115 (Mumbai). In that case,
the assessee, a pharmaceutical company, in the computation of income had shown
long term capital loss on sale of shares amounting to Rs.57,32,835 and loss on
sale of mutual funds units amounting to Rs.2,61,655. The said long term capital
loss had been set off against the long term capital gains of Rs.94,12,00,000
arising from sale of land at Chennai. The AO held that the losses claimed could
not be allowed since the income from long term capital gain on sale of shares
and mutual funds was exempt u/s. 10(38) of the Act of 1961. He held that the
long term capital loss in respect of shares, where securities transaction tax
had been paid, would have been exempt from long term capital gain had there
been profits, and therefore, long term capital loss from sale of shares could
not be set off against the long term capital gain arising out of the sale of
land. The CIT(A) confirmed the action of the AO on the ground that exempt
profit or loss construed separate species of income or loss and such exempt
species of income or loss could not be set off against the taxable species of
income or loss. He held that the tax exempt losses could not be deducted from
taxable income and, therefore, the AO had rightly disallowed the claim of
losses from shares to be set off against the long term capital gain from sale
of land. The assesseee company in appeal to the Tribunal raised the following
grounds; ‘1.1 On the facts and circumstances of the case and in law, the
learned Commissioner of Income-tax (Appeals) – Central II, Mumbai [“the
CIT(A)”] erred in confirming the action of Deputy Commissioner of Income
Tax (the A.O) by not allowing the claim of set off of Long term Capital Loss on
sale of shares where Security Transaction Tax (“STT”) was deducted
against the Long Term Capital Gain arising on sale of land at Chennai; 1.2 the
appellant prays that such set off of the said Long Term Capital Loss be
allowed;

It was submitted that what was contemplated
in section 10(38) was exemption of positive income and losses would not come
within the purview of the said section; the set off of long term capital loss
had been clearly provided in sections 70 and 71; the legislation had not put
any embargo to exclude long term capital loss from sale of shares to be set off
against long term capital gain arising on account of sale of other capital
asset; even in the definition of capital asset u/s. 2(14), no exception or exclusion
had been provided to equity shares the profit/gain of which were treated as
exempt u/s. 10(38); capital gain was chargeable on transfer of a capital asset
u/s. 45 and mode of computation had been elaborated in section 48; certain
exceptions had been provided in section 47 to those transactions which were not
regarded as transfer; nothing had been mentioned in sections 45 to 48 that
capital gain or loss on sale of shares were to be excluded as section 10(38)
exempted the income arising from the transfer of long term capital asset being
an equity share or unit; legislature had given exemption to income arising from
transfer of long term capital asset being an equity share in company or unit of
equity oriented fund, which was chargeable to STT; section 10(38) could not be
read into section 70 or 71 or sections 45 to 48.

The assessee supported the contention by
relying upon the decision of the Calcutta High Court in the case of Royal
Calcutta Turf Club vs. CIT, 144 ITR 709 to submit that similar issue with regard
to the losses on account of breeding horses and pigs which were exempt u/s.
10(27), whether it could be set off against its income from a business source
was considered and the High Court after considering the relevant provisions of
section 10(27) and section 70, had held that section 10(27) excluded in
expressed terms only any income derived from business of livestock breeding,
poultry or dairy farming and did not exclude the business of livestock
breeding, poultry or dairy farming from the operation of the Act. The losses
suffered by the assessee in respect of livestock, breeding were held to be
admissible for deduction by the court and were allowed to be set off against
other business income. It was pointed out that the court in turn had relied on various
decisions, especially in the case of CIT vs. Karamchand Premchand Ltd.40 ITR
106(SC). It was pointed out that there was a decision of the Gujarat High
Court in the case of Kishorebhai Bhikhabhai Virani vs. Asstt. CIT, 367
ITR 261, which had decided the issue against the assessee and the said decision
had not referred to the decisionof the Calcutta High Court at all and
therefore, did not have precedence value as compared to the Calcutta High Court
decision, which was based on Supreme Court decision on the point. Also pointed
out was the fact that the ITAT Mumbai bench also in the case of Schrader
Duncan Ltd. vs. Addl. CIT 50 SOT 68 had decided a somewhat similar issue
against the assessee but was distinguished.

On the other hand, the Revenue strongly
relied upon the order of the AO and CIT(A) and submitted that, firstly, if the
income from the long term capital gain on sale of shares was exempt, then the
loss from such sale of shares would also not form part of the total income and
therefore, there was no question of set off against other income or long term
capital gain on different capital asset. Secondly, the decisions of the Gujarat
High Court and ITAT Mumbai bench were required to be followed. It was further submitted
that it was quite a settled law that income included loss also and, therefore,
if the income from sale of shares did not form part of the total income, then
the losses from such shares also would not form part of the total income.

The Mumbai Tribunal on the conjoint reading
and plain understanding of all the sections observed that;

–   firstly,
shares in the company were treated as capital asset and no exception had been
carved out in section 2(14), for excluding the equity shares and unit of equity
oriented funds that they were not treated as capital asset;

–   secondly,
any gains arising from transfer of Long term capital asset was treated as
capital gain which was chargeable u/s. 45;

–  thirdly,
section 47 did not enlist any such exception that transfer of long term equity
shares/funds were not treated as transfer for the purpose of section 45, and
section 48 provides for computation of capital gain, which was arrived at after
deducting cost of acquisition i.e., cost of any improvement and expenditure
incurred in connection with transfer of capital asset, even for arriving of
gain in transfer of equity shares;

–   sections
70 & 71 elaborated the mechanism for set off of capital gain. Nowhere, any
exception had been made/carved out with regard to Long term capital gain
arising on sale of equity shares. The whole genre of income under the head
‘capital gain’ on transfer of shares was a source, which was taxable under the
Act. If the entire source was exempt or was considered as not to be included
while computing the total income then in such a case, the profit or loss
resulting from such a source did not enter into the computation at all.
However, if a part of the source was exempt by virtue of particular
“provision” of the Act for providing benefit to the assessee, then it
could not be held that the entire source would not enter into computation of
total income.

–  the
concept of income including loss would apply only when the entire source was
exempt and not in the cases where only one particular stream of income falling
within a source was falling within exempt provisions. Section 10(38) provided
exemption of income only from transfer of long term equity shares and equity
oriented fund and not only that, there are certain conditions stipulated for exempting
such income and as such exempted only a part of the source of capital gain on
shares.

–  it
needed to be seen whether section 10(38) exempted the source of income which
did not enter into computation at all or only a part of the source, the income
in respect of which was excluded in the computation of total income.

–   the
precise issue had come up for consideration before the Calcutta High Court in Royal
Calcutta Turf Club’s case (supra), wherein the court observed that “under
the Income tax Act, 1961 there are certain incomes which do not enter into the
computation of the total income at all. In computing the total income of a
resident assessee, certain incomes are not included under s.10 of the Act. It
depends on the particular case; where the Act is made inapplicable to income
from a certain source under the scheme of the Act, the profit and loss
resulting from such a source will not enter into the computation at all. But
there are other sources which, for certain economic reasons, are not included or
excluded by the will of the Legislature. In such a case, one must look to the
specific exclusion that has been made.” The court relying specifically
on the decision of in the case of Karamchand Premchand Ltd. (supra),
came to the conclusion that “cl.(27) of s.10 excludes in express terms
only “any income derived from a business of live-stock breeding or poultry
or dairy farming. It does not exclude the business of livestock breeding or
poultry or dairy farming from the operation of the Act. Therefore, the losses
suffered by the assessee in the broodmares account and in the pig account were
admissible deductions in computing its total income”

–   the
decision in the case of Schrader Duncan Ltd. (supra), the issue
involved was slightly distinguishable and secondly, the ratio of Calcutta High
Court was applicable in the case before them. Lastly, the decision of the
Gujarat High Court in the case of Kishorebhai Bhikhabhai Virani (supra),
though the issue involved was almost the same, and was decided against the assessee,
the ratio of the decision of the Calcutta High Court was to be followed more so
where the said decision had not been referred or distinguished by the Gujarat
High Court.

The Mumbai bench of the Tribunal finally
held that the ratio laid down by the Calcutta High Court was clearly applicable
and accordingly was to be followed in the case before them to conclude that
section 10(38) excluded in expressed terms only the income arising from
transfer of long term capital asset being equity share or equity fund which was
chargeable to STT and not entire source of income from capital gains arising
from transfer of shares and that the provision of section 10(38) did not lead
to exclusion of the entire source and not even income from capital gains on
transfer of shares. Accordingly, long term capital loss on sale of shares was
allowed to be set off against long term capital gain on sale of land in
accordance with section 70(3) of the Act.

Observations

The issue being considered here has a long
history. Time and again, it has been subjected to judicial inspection including
by the Supreme Court and in spite of the decisions of the Apex court,
conflicting decisions are being delivered by the courts on the subject as was
highlighted by this feature published in BCAJ, some 25 years ago.

The Supreme court in the case of Harprasad
& Co. (P) Ltd. 99 ITR 118 (SC) (supra) held that losses from a
source, the income whereof did not enter into computation of total income, was
not eligible for set-off against income from other sources. The Supreme court
in yet another case, Karamchand Premchand & Co. (supra),
narrated the circumstances where the losses of the  given nature were eligible for set-off.

One would have thought the issue of set-off
was settled with the Supreme court decisions on the subject, but as is pointed
out by the conflicting decisions of the Tribunal that the issue is alive and
kicking. Subsequent to the Apex court decisions, the Madras High Court in the
case S.S. Thiagarajan 129 ITR 115(Mad) examined the issue to decide
against the eligibility for set-off of such losses from an exempt source of
income. In that case, the assessee had incurred losses on his activity of
racing and betting on horses, the income whereof was otherwise exempt u/s.
10(3) of the Income-tax Act. Subsequently, the Calcutta High Court in the case
of Royal Calcutta Turf Club 144 ITR 709 held that the losses from a
source, the income whereof was otherwise exempt, was eligible for set-off
against income from other sources. In that case, the assessee club had incurred
losses on its activities of livestock breeding, dairy farming and poultry
farming, the income whereof was exempt from taxation under the then section
10(27) of the Act and had sought its set off against the income from dividend
which was then taxable. In deciding the issue, the High Court took notice of
the decision of the Madras High Court in the case of S.S. Thiagarajan (supra)
and dissented from the ratio of the said decision.

A finer distinction is to be kept in mind,
for supporting the claim, between a case where an income does not enter into
computation of total income per se, as per the scheme of taxation, for
e.g., an agricultural income or a capital receipt as against the case of an
income, otherwise taxable, but has been exempted expressly from taxation for
economic reasons or where a part thereof only is exempted and not the entire
source thereof or a case where the exemption is conditional. It is believed
that in the later cases, where the exemption is conferred for economic reasons
and few other reasons cited, the law otherwise settled by the Supreme Court in
the case of Harprasad & Co. should not apply. Needless to say that
the exemption, u/s. 10(38) for long term capital gains on sale of shares was
given for economic reasons of developing the securities market and was also
otherwise a case quid pro quo inasmuch as exemption was only on payment
of another direct tax namely STT and in any case is conditional and further, is
not for all types of capital gains.

There also is a merit in the contention that
section 10(38) deals with the case of an ‘income’ alone and should not be
stretched to include the case of a ‘loss’ and principle that an ‘income
includes loss ‘should not be applicable to the provision of section 10(38) of
the Act.

Section 10(38) is a beneficial provision
introduced to help the tax payers to minimise their tax burden, once an STT is
paid. In the circumstances, it is in the fitness of the things that the
provisions are construed liberally in favour of the exemption. Bajaj Tempo
Ltd., 196 ITR 188(SC). The fact that the issue of eligibility of setoff is
controversial and is capable of two conflicting views is highlighted by the two
opposing decisions discussed here and therefore, a view favourable to the tax
payer, in such cases, should be taken. Vegetable Products, 88 ITR 192 (SC).

In Harprasad & Co.‘s case (supra)
, the assessee claimed capital loss on sale of shares of Rs.28,662 during the
previous year relevant to assessment year 1955-56. The AO disallowed the loss
on the ground that it was a loss of a capital nature and the CIT (A) confirmed
his order. Before the Tribunal, the assessee modified its claim and sought that
the loss which had been held to be a ” capital loss ” by the authorities
below, should be allowed to be carried forward and set off against profits and
gains, if any, under the head ” capital gains ” earned in future, as
laid down in sub-sections (2A) and (2B) of section 24 of the Act of 1922. The
Tribunal accepted the contention of the assessee and directed that the ”
capital loss ” of Rs. 28,662  
should  be  carried 
forward  and  set off 
against  ” capital gains “, if any, in
future. On appeal, the Delhi High Court confirmed the order of the tribunal.

On further appeal by the Revenue, the
Supreme Court considered: “Whether, on the facts and in the
circumstances of the case, the capital loss of Rs. 28,662 could be determined
and carried forward in accordance with the provisions of section 24 of the
Indian Income-tax Act, 1922, when the provisions of section 12B of the
Income-tax Act, 1922, itself were not applicable in the assessment year 1955-
56. “The Court, on due consideration of facts and the law, held: ‘Under
the Income Tax Act, 1922, capital gain was not included as a head of income and
therefore capital gain did not form part of the total income. Certain important
amendments were effected in the Income-tax Act by Act XXII of 1947. A new
definition of ” capital asset ” was inserted as Section 2(4A) and
” capital asset ” was defined as ” property of any kind held by
an assessee, whether or not connected with his business, profession or vocation
“, and the definition then excluded certain properties mentioned in that
clause. The definition of ” income ” was also expanded, and ” income
” was defined so as to include ” any capital gain chargeable
according to the provisions of Section 12B “. Section 6 of the Income-tax
Act was also amended by including therein an additional head of income, and
that additional head was ” capital gains, ” Section 12B, provided
that the tax shall be payable by an assessee under the head ” capital
gains ” in respect of any profits or gains arising from the sale, exchange
or transfer of a capital asset effected after 31st March, 1946, and that such
profits and gains shall be deemed to be income of the previous year in which
the sale, exchange or transfer took place. The Indian Finance Act, 1949,
virtually abolished the levy and restricted the operation of section 12B to
” capital gains ” arising before the 1st April, 1948. But section
12B, in its restricted form, and the VIth head, ” capital gains ” in
section 6, and sub-sections (2A) and (2B) of section 24 were not deleted and
continued to form part of the Act. The Finance (No. 3) Act, 1956, reintroduced the
” capital gains ” tax with effect from the 31st March, 1956. It
substantially altered the old section 12B and brought it into its present form.
As a result of the Finance (No. 3) Act of 1956, “capital gains ”
again became taxable in the assessment year 1957-58. The position that emerges
is that ” capital gains ” arising between April 1, 1948, and March
31, 1956, were not taxable. The capital loss in question related to this
period.’

In Karamchand Premchand & Co. Ltd.
(supra) the court held ; “What it says in express terms is that the Act
shall not apply to any incosme, profits or gains of business accruing or
arising in an Indian State etc. It does not say that the business itself is
excluded from the purview of the Act. We have to read and construe the third
proviso in the context of the substantive part of section 5 which takes in the
Baroda business and the phraseology of the first and second provisos thereto,
which clearly uses the language of excluding the business referred to therein.
The third proviso does not use that language and what learned counsel for the
appellant(Revenue) is seeking to do is to alter the language of the proviso so
as to make it read as though it excluded business the income, profits or gains
of which accrue or arise in an Indian State. The difficulty is that the third
proviso does not say so; on the contrary, it uses language which merely exempts
from tax the income, profits or gains unless such income, profits or gains are
received in or brought into India”. It went on to hold “ Next, we have to
consider what the expression “income, profits or gains” means. In the
context of the third proviso, it cannot include losses ……….. and the expression
“income, profits or gains” in the context cannot include losses. ………
The appellant(Revenue) cannot therefore say that the third proviso excludes the
business altogether, because it takes away from the ambit of the Act not only
income, profits or gains but also losses of the business referred to therein.”
Lastly, “The argument merely takes us back to the question—does the third
proviso to section 5 of the Act merely exempt the income, profits or gains or
does it exclude the business ? If it excludes the business, the appellant
(Revenue) is right in saying that the position under the proviso is not the
same as under section 14(2)(c) of the Indian Income-tax Act. If on the contrary
the proviso merely exempts the income, profits or gains of the business to
which the Act otherwise applies, then the position is the same as under section
14(2)(c). It is perhaps repetition, but we may emphasize again that exclusion,
if any, must be done with reference to business, which is the unit of taxation.
The first and second provisos to section 5 do that, but the third proviso does
not.”

The Mumbai bench of the Tribunal, in
deciding the issue in favour of the assessee, has taken due note of the direct
decision of Gujarat High Court in the case of Kishore Bhikhabhai Virani,
(supra) which in turn had followed the decision of Madras High Court in S.S.
Thiagarajan’s case(supra) and chose to chart a different course of
action for itself only after due consideration of the law on the subject. The
Kolkata bench of the Tribunal has however followed the said decision of the
Gujarat High Court to arrive at the opposite conclusion.

In deciding the issues before them, both the
High Courts have based their decisions on the different decisions of the
Supreme court, one in the case of Harprasad & Co.(supra) and
the other in the case of Karamchand Premchand Ltd.(supra). The
Mumbai bench has dutifully examined the ratio of these decisions of the Supreme
court while applying one of the ratios of the decisions of the high courts. It
has also examined the application or otherwise of the direct decision of the
Gujarat High Court. In that view of the matter, the decision of the Mumbai
bench is the only decision which has examined the issue with its various facets
and has brought on record a very detailed analysis of a vexatious and complex
issue on due application of judicial process. The better view, in our humble
opinion, is in favour of allowance of the set-off of losses against income from
other sources, for the reasons discussed here. _